The Advisors' Blog

A recent consulting assignment highlighted the need to push back when faulty thinking threatens not only outcome but the process of executive pay determination. A CEO pushing for a renewal of his expiring 3-year contract felt ‘under-optioned” due to an odd history of Board decisions. He was requesting a 3-year front-loaded option grant and a fixed 3-year deal with all options vesting during that period. He hit a stalemate with the CC who felt something wasn’t right about his request and needed an independent viewpoint.

The outcome was one that satisfied all parties: an option grant 3x the normal number of shares in annual grant but with a 25% premium price and vesting consistent with a series of three annual grants (11-22-33-22-11%) rather than the company’s standard 3 x 33% vesting. He gets the advantage of the front-loaded grant only if the company outperforms.

The process of getting to this point was difficult. We emphasized a scenario-based tally sheet and analysis to refocus the CC and the CEO from the new option grant potential gains to the total gains from previous options plus the new one. This changed both parties’ thinking from the vesting-date based analysis to the post-vesting “tail” value of the options.

We all face the inertia of the old-school notion that “pay is annual” (reinforced by the SEC and financial reporting cycles) and that “value ends at vesting or expected life” (reinforced by FAS123R). I frequently emphasize the idea of “checkerboard pay” – every year looks different – and the cumulative uneven value of those patterns must be understood. Even more important now that the mix of SO, RS, Cash LTI, etc changes year to year and the pressure to retain options and/or shares has become an element of the pay package. The only way to understand the cumulative effects of decisions is looking back multi-year and looking forward multi-year.

With this client, I had to politely ignore both the Committee’s and CEO’s instructions to omit the previous option grants on the tally sheet because they were “irrelevant” – I guess that’s a little compensation consultant civil disobedience. When they saw the numbers with stock price projections, however, it changed everyone’s attitude and they requested that we show additional future years in the projection. Suddenly we weren’t talking about $2mm vs. $4mm but about $16mm vs. $18mm, and then $26mm vs. $30mm.

We had to emphasize a number of concepts to the Compensation Committee including:

– Truncation of option value is voluntary, not built into the option other than the term itself which is rarely a constraint. Vesting doesn’t end value accumulation, exercise only ends the tax-withheld part of value accumulation, and employment termination only affects the unvested AND unprotected (unaccelerated) part of value accumulation.

– Stock price projections are estimates, but better estimates than Black-Scholes values, and emphasize the “shareholder value commission” aspect of equity-based pay. If the projections are wrong the pay is self-correcting. The dollar value projections have to be accompanied by percent-of-outstanding analyses.

– We never, ever, ever, use accounting numbers in pay analysis. Options aren’t worth less because you paid an actuary to reduce your BS assumptions (pardon my acronym). RSUs are not worth face value at grant, they’re worth more. Conversely, performance shares are not worth the maximum payout just because you’re accruing that so you can reverse some of the expense later when EPS needs a boost. The complexity of LTI numbers require some thoughtful analysis, not FAS123R adherence.

– Despite the best efforts of “free agent” negotiators’ mentality, executive work is not professional sports and no one ever had to retire early from a knee injury sustained on a conference call with analysts. Let the sports analogy go. Shareholders should expect, and reward, continued performance-positive employment. And someone quitting at age 50 is not “retiring” they are quitting.

And yes, I’m still their consultant. Neither the CEO nor the CC fired me because I said “no”. But if they do, that’s fine too.

– Fred Whittlesey